a forum for news, ideas and commentary on the art and science of long-term investing

Falling ETF Fees and What They Mean

Vanguard has just reduced the expense ratios of 24 of its ETFs. The reductions are fairly substantial. What I noticed, in particular, is that the reductions include sector-specific ETFs.

The Vanguard Energy ETF (VDE), the Vanguard Information Technology ETF (VGT), the Vanguard Telecom ETF (VOX), and the Vanguard Utility ETF (VPU) each now have 0.14% expense ratios vs. 0.19% previously. While the expense ratios of these funds were already low, the new expenses are 26% lower than before.

There are already ultra low-cost ETFs that track total stock market and total bond indexes. The Vanguard Total Stock Market Index ETF (VTI) has an expense ratio of 0.06% and the Vanguard Total Bond Market ETF (BND) has an expense ratio of 0.1%. Investors who hold most or all of their assets in total stock market funds are betting that a global market cap weighted portfolio is the best solution. For stocks, this assumption has major implications. In market cap weighted stock indexes, the amount of the portfolio invested in a stock is determined by the total market value of the stock. The more a company is worth, the larger the allocation to it. This approach results in some interesting outcomes. An investor in VTI currently has a 3.95% allocation to a single stock: Apple (AAPL). The second-largest allocation is to Exxon (XOM) at 2.7%. Apple is a great company, but there are reasonable arguments that investors may not want almost 4% of their total equity allocation in this one company, for example.

The alternative to investing in total market indexes is to use a strategy that selectively allocates across sectors. Having sector ETFs lower their expenses is especially helpful for asset allocation strategies that choose specific parts of the market to be over-weight or under-weight relative to the market cap weighted indexes. Folio Investing’s Target Date Folios, for example, are allocated to equity sector ETFs and to specific classes of bond ETFs rather than total market index funds. The rationale for this sector-focused allocation is largely correlations between sub-sectors. The lower the correlation between sub-sectors, the more expected return you can target at a given level of risk. By picking and choosing from among sectors and bond types, we attempt to maximize the diversification benefits reaped by a portfolio while limiting risk. The Target Date Folios include a number of Vanguard’s sector ETFs.

A portfolio of ETFs which emphasizes specific sectors and types of bonds will undoubtedly have a higher expense ratio than one that is invested in ‘total market’ index funds. The reduction in prices of sector ETFs reduces the penalty for investors who choose asset allocations comprised of sector funds. My research suggests that a sector-based approach to asset allocation can be expected to add between 1% and 2% per year in additional return as compared to market cap based allocation, so the higher-cost sector funds appear to be well worth the additional cost. The reduction in the costs of sectors funds will certainly be helpful, however.

A range of experts have noted that there are compelling reasons for choosing asset allocations that diverge from simply investing in total market indexes, including Burton Malkiel, one of the earliest champions of index investing. Folio Investing’s experience with the Target Date Folios has also reinforced the research that suggests a benefit to sector-based allocations. The reduction in expense ratios of sector ETFs increasingly reduces the cost penalty of such an approach.

About Geoff Considine

After earning his Ph.D. in Atmospheric Science, Geoff worked for NASA for 3 years, leaving to become a quantitative analyst developing trading and portfolio management solutions for Aquila Energy. Leaving Aquila in 2000, Geoff became a consultant focusing on quantitative methods in portfolio management. Geoff founded Quantext in March 2002.
Geoff has published commentary and analysis in a range of publications, including Advisor Perspectives, Financial-Planning.com, and Horsesmouth.com.
Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com (http://www.foliofn.com)).
Neither Quantext nor Geoff Considine is an investment advisor.

What Type of Investor Are You?

Understanding your investing profile to achieve your financial goals starts with a few simple questions. The Investor Questionnaire, by Folio Investing, will help you understand your investment time horizon, investor profile and level of risk.